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January 21, 2019

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Piercing the Corporate Veil

A properly formed and operated corporation or LLC offers its owners limited liability for the debts of the business, so that their losses are limited to their investment in the business. In some extreme and rare
cases, however, courts hold the owners liable for the debts of the
company, including for judgments resulting from lawsuits. In legal
terminology, this is called "piercing the corporate veil."

Courts normally pierce the corporate veil in situations where
one owner or a small group of owners dominate the management and
operation of the corporation or LLC. Without more, the combination of
ownership and management is not a problem (indeed, LLCs are designed to
be managed that way). The problem arises when one or more of the
following factors are present:

Misuse of Corporate/LLC Funds. Courts look at whether a
dominant shareholder or owner treats the assets of the corporation or
LLC as if they were his own. This could involve a shareholder or owner
intentionally siphoning off company assets for personal benefit.
Alternatively, it could involve a shareholder or owner co-mingling
company bank accounts and records with her own, and failing to keep
good records of transactions between the company and herself. To avoid
veil-piercing liability, you should never cause your company to pay you
an amount of money that will render it insolvent (meaning, that the
company's assets are less than its liabilities or it is unable to pay
its bills as they become due). Additionally, you should always maintain
a separate bank account for your company and keep separate financial
records.

Undercapitalization. Courts also look at whether a
corporation or LLC is undercapitalized. The exact definition of
"undercapitalized" is not entirely clear, and the definition changes
depending on the nature of the business. However, it is clear that you
should never intentionally keep your company in a state where it lacks
the assets necessary to pay its creditors. On the contrary, you and the
other shareholders or owners (if any) should make a reasonable initial
investment in the company. You don't necessarily need to put in so much
money that you can cover all foreseeable needs or debts of the business
(after all, businesses are permitted to take out loans, and they do so
all the time), but you should invest enough so that you take on a
"fair" share of the risks of business failure.

Failure to Observe Corporate Formalities. Courts
sometimes consider the extent the owner or owners of a business have
disregarded corporate formalities. Among the types of conduct that
might constitute "disregard of formalities" are

failure to issue stock;

failure to have shareholder meetings to elect directors, or to
hold director meetings, or to prepare minutes of these meetings; and

failure to formally approve or carefully document transactions between the business and its shareholders or members.

This factor generally is more relevant to corporations, because
LLCs do not require the same kinds of operating formalities. However,
in order to maintain their limited liability protection, LLC members
should observe certain formalities, such as keeping detailed financial
records and recording minutes of major decisions.

Fraud. Courts also examine whether the dominant
shareholder or owner uses the company to perpetrate a fraud or makes
fraudulent representations about the business. As one commentator
notes, this category can be seen as "a general catch-all prong which
allows courts to disregard a legal entity when they feel like someone
has complied with the letter, but not the spirit, of the law." This
could involve making misrepresentations about the corporation's
financial status, promising that the corporation will perform its
obligations while knowing that this is impossible (or intending to do
otherwise), or making representations that would lead a creditor to
believe that someone, other than the corporation, stands behind a debt.
But it could potentially cover much subtler forms of misrepresentation
or wrongful conduct. As a practical matter, unless you intend to assume
liability yourself, you should never make verbal assurances to
creditors that you will pay the debts of the corporation if it is
unable to meet its obligations. Most importantly, you should always be
upfront and honest when communicating with creditors and/or clients of
your business.

The presence of one or another of these factors does not
automatically result in piercing the corporate veil. The analysis that
courts perform is fact-intensive and unpredictable. The presence of two
or more of these factors, however, would make it more likely that a
court would disregard the corporate/LLC form and hold you personally
liable for the debts of the business.

Note: No piercing of the corporate veil is necessary to hold
you personally liable for your own unlawful actions, such as if you
write a defamatory article or blog post. In that case, you are
independently liable for the injury done. The LLC or corporation may
also be liable, but a plaintiff could satisfy the judgment out of your
personal assets should the company's assets prove insufficient.

Best Practices for Avoiding Piercing the Corporate Veil

Never cause your corporation or LLC to pay you an amount that
would render it insolvent, or any amount that would seem unreasonable
to an outside observer. Document the justifications for large payments
made to shareholders or members.

Keep separate financial records for your business and
yourself, and maintain a separate bank account for the business. Avoid
borrowing money from the company for personal expenses. If you
absolutely have to withdraw funds from the business, make sure that you
keep accurate records of how much was borrowed and when you paid it
back. Charge yourself a reasonable interest rate for the loan.

Do not verbally assure creditors that you will personally
take on the obligations of the corporation if the company proves unable
to do so. Do not blend corporate and personal obligations.

If you operate as a corporation, make sure to observe the
required corporate formalities, such as issuing stock, holding
shareholder and board of directors meetings, keeping adequate minutes
for meetings, and formally approving and documenting any transactions
between the company and shareholders. For more on required corporate
formalities, see the Corporation and the Corporate Records sections.

If you operate as an LLC, the same formalities are not
required, but LLC members should observe certain formalities, such as
keeping detailed financial records and recording minutes of major
decisions.

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Disclaimer

Information in this guide is based on general principles of law and is intended for information purposes only; we make no claim as to the comprehensiveness or accuracy of the information. It is not offered for the purpose of providing individualized legal advice. Use of this guide does not create an attorney-client or any other relationship between the user and the Digital Media Law Project or the Berkman Center for Internet & Society.

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